For the financial trading novice, this chapter will help you to learn the very basics of futures trading. You'll learn some of the important terminology of the trade, as well as how to place bids, sell, and monitor the market.

This chapter is from the book

Picking up the phone and instructing your broker to buy or sell is
relatively simple. Performing a few mouse clicks and transmitting your order to
a handheld device in the pit or to a totally electronic marketplace isn't all
that hard either. It's really not all that difficult to understand how the money
works. What is difficult, however, is extracting profits from the markets (something
we'll tackle later in this book), but you have to start somewhere. This chapter
is for those of you who need to learn the basics. So here we begin, as good a
place to start as any.

Commodities are not only essential to life, but
they are absolutely necessary for quality of life. Every person eats. Billions
of dollars of agricultural products are traded daily on the world's commodity
exchangeseverything from soybeans to rice, corn, wheat, beef, pork, cocoa,
coffee, sugar, and orange juice. Food is where the commodity exchanges began.

In the middle of the nineteenth century in the United States, businessmen
started organizing market forums to facilitate the buying and selling of agricultural
commodities. Over time, farmers and grain merchants met in central marketplaces
to set quality and quantity standards and to establish rules of business. In the
course of only a few decades, more than 1,600 Exchanges sprung up at major railheads,
inland water ports, and seaports. In the early twentieth century, as communications
and transportation became more efficient, centralized warehouses were constructed
in major urban centers such as Chicago. Business became less regional, more national;
many of the smaller Exchanges disappeared.

In today's global marketplace,
approximately 30 major Exchanges remain, with 80% of the world's business conducted
on about a dozen of them. Just about every major commodity vital to commerce,
and therefore to life, is represented. Billions of dollars worth of energy productsfrom
heating oil to gasoline to natural gas and electricityare traded every business
day. How could we live without industrial metals (copper, aluminum, zinc, lead,
palladium, nickel, and tin); precious metals such as gold; or platinum and silver,
which are considered both industrial and precious metals? How could we live without
wood products or textiles? It would be hard to imagine life without them, and
yet few people are aware of just how the prices for these vital components of
life are set. Unlike 100 years ago, today the world's futures Exchanges also trade
financial products essential to the global economic function. From currencies
to interest rate futures to stock market indices, more money changes hands on
the world's commodity exchanges every day than on all the world's stock markets
combined.

Governments allow commodity exchanges to exist so that producers
and users of commodities can hedge their price risks. However, without
the speculator, the system would not work. Anyone can be a speculator, and contrary
to popular belief, I do not believe the odds need be stacked against the individual.
In this book, I plan to share with you techniques designed to help you make money
trading commodities. Actually, you as an individual have one distinct advantage
over the big players, and that's flexibility. You can move quickly, like a cat,
something a giant corporation can't do. Many times, several of the big commercial
operators that utilize the Exchange for hedging literally hand you your profits
on a silver platterthey're there for a different reason. So, let's start
by looking at how the futures contract works and the various participants in the
marketplace. We'll also look at what they are attempting to accomplish and how
they interact with each other.

Futures markets and the futures contract

Futures
markets, in their most basic form, are markets in which commodities (or financial
products) to be delivered or purchased at some time in the future are bought and
sold.

The futures contract is the basic unit of exchange in the
futures markets. Each contract is for a set quantity of some commodity or financial
asset and can be traded only in multiples of that amount. The futures contract
is a legally binding agreement that provides for the delivery of various commodities
or financial entities at a specific time period in the future. (Prior to the time
I was in this business, I envisioned the parties sitting at a table and actually
signing paper contracts. It's nothing like that.)

When you buy or sell
a futures contract, you don't actually sign a contract drawn up by a lawyer. Instead,
you're entering into a contractual obligation that can be met in only one of two
ways. The first method is by making or taking delivery of the actual commodity.
This is by far the exception, not the rule. Less than 2% of all futures contracts
are concluded with an actual delivery. The other way to meet this obligation,
which is the method you most likely will be using, is offset. Very simply, offset
is making the opposite (or offsetting) sale or purchase of the same number of
contracts bought or sold sometime prior to the expiration date of the contract.
Because futures contracts are standardized, this is accomplished easily.

Every
contract on a particular Exchange for a specific commodity is identical except
for price. The specifications are different for each commodity, but the contract
in each market is the same. In other words, every soybean contract traded on the
Chicago Board of Trade is for 5,000 bushels. Every gold contract traded on the
New York Mercantile is for 100 troy ounces. Each contract listed on an Exchange
calls for a specific grade and quality. For example, the silver contract is for
5,000 troy ounces of 99.99% pure silver in ingot form. The rules state that the
seller cannot deliver 99.95% pure. Therefore, the buyers and sellers know exactly
what they are trading. Every contract is completely interchangeable. The only
negotiable feature of a futures contract is price.

The size of the contract
determines its value. To calculate how much money you could make or lose on a
particular price movement of a specific commodity, you need to know the following:

Contract size

How the price is quoted

Minimum price fluctuation

Value of the minimum price fluctuation

The
contract size is standardized. The minimum unit tradable is one contract. For
example, a New York coffee contract is for 37,500 pounds, a Chicago corn contract
is for 5,000 bushels, and a British Pound contract calls for delivery of 62,500
Pounds Sterling. The contract size determines the value of a move in price.

You
also need to know how prices are quoted. For example, grains are quoted in dollars
and cents per bushel: $2.50 per bushel for corn, $5.50 per bushel for wheat, and
so on. Copper is quoted in cents per pound in New York, and dollars per metric
ton in London. Cattle and hogs are quoted in cents per pound, whereas gold is
quoted in dollars and cents per troy ounce. Currencies are quoted in the United
States in cents per unit of currency. As you begin trading, you will quickly become
familiar with how this works. Your commodity broker can fill you in on how prices
are quoted on any particular market you decide to trade.

The minimum price
fluctuation, also known as a "tick," is a function of how prices are
quoted and is set by the Exchange.

For example, prices
of corn are quoted in dollars and cents per bushel, but the minimum price fluctuation
corn can move is 1/4¢ per bushel. So if the price of corn is $3.00/bushel,
the next price tick can either be $3.00 1/4 (if up) or $2.99 and 3/4 (if down).
Prices can trade more than a tick at a time, so in a fast market, the price could
jump from $3.00 to $3.00 1/2, but it could not jump from $3.00 1/2 to $3.00 and
5/8 because the minimum price fluctuation for corn is a quarter penny. Therefore,
the next minimum price tick for corn from $3.00 1/2 up would be $3.00 3/4, or
down would be $3.00 1/4. The minimum price fluctuation for a gold contract is
10¢/ounce, so if gold is trading for $425.50 per ounce, the minimum it can
move in price would be $425.60 if up, or $425.40 if down. Once again, in a fast
market, or if the bids and offers are wide, it might jump from $425.50 to $426,
but in liquid and quiet markets, many times the market moves from one minimum
tick fluctuation to the next.

The value of a minimum
fluctuation is the dollars and cents equivalent of the minimum price fluctuation
multiplied by the contract size of the commodity.

For example, the
size of a copper contract traded in New York is 25,000 pounds. The minimum price
fluctuation of a copper contract is 5/100 of one cent per pound (or 1/20 of one
cent). By multiplying the minimum price fluctuation by the size of the contract,
you obtain the value of the minimum price fluctuation, which in this case is $12.50
(1/20¢ per pound times 25,000 pounds). In the case of the grains and soybeans,
a minimum price fluctuation is 1/4¢ and a contract is for 5,000 bushels,
so the value of a minimum fluctuation is also $12.50 (1/4¢ per bushel times
5,000 bushels).

Except for grains, minimum fluctuations
are generally quoted in points.

For example, sugar
prices are quoted in cents and hundredths of a cent per pound. The minimum fluctuation
is 1/100 of one cent, or one point. If the price is quoted at 15 1/2 cents per
pound, your broker would say it is trading at 1550, and if it moves up by a quarter
of a cent per pound, this would be a move of 25 points, to 1575.

In some cases, the value of a minimum move may be more than a point.
In the copper example, the minimum move is 1/20¢ per pound. A penny move
is 100 points (for example, if copper prices rise from $1 per pound to $1.02 per
pound, the market has moved up 200 points), but because the minimum fluctuation
is for 1/20¢, a minimum move is 5 points, or $12.50 per contract. A move
of 1¢ is worth $250, which is 100 points. You must understand what the value
of a move is for the commodity you are trading. For example, if you are trading
soybeans, you should know that a move of 1¢ is worth $50 per contract (either
up or down), and if you buy three contracts and the market closes up 10¢
that day, you would make $1,500, or $500 per contract. If the market closes down
10¢, you would lose the same amount. Although this might seem confusing at
first, you'll quickly understand the value of a minimum fluctuation and the value
of a point at the time you write that check for your first margin call. That reminds
me of an amusing true story told to me by my favorite copper broker.

On the floor of the COMEX (the world's largest metals Exchange), where
copper is traded, the pit brokers always talk in terms of points instead of dollar
values. You might hear a trader saying, "I made 300 points today," or
"I lost 150 points on that trade." A number of years ago, there was
a big commission house broker (a floor broker who makes his living filling buy
and sell orders from customers who call in from off the floor) who was pressured
by his wife to hire his brother-in-law. The brother-in-law wasn't all that bright,
but the broker felt his brother-in-law couldn't do that much damage if he were
on the phone as a clerk. After all, the clerks just take the buy and sell orders
over the phone and run them into the pit to be filled.

Well, everything
went reasonably well for a few weeks, and then the first inevitable error occurred.
Apparently, the brother-in-law took an order to buy five contracts, and he wrote
"sell" on the order ticket. By the time the error was discovered, it
had resulted in a loss of 370 points ($925) that the commission house broker had
to make good. After the market closed, the broker took the brother-in-law aside
and carefully spoke to him.

The broker said, "Look, mistakes happen
and, fortunately, this error was for only 370 points. It could have been much
worse, but you have to be more careful. We cannot afford to have any more errors
like this one."

The brother-in-law replied, "What are you getting
so hot under the collar for? Sure I made a mistake, but it's only points."

To
this day, whenever anyone makes an error in the copper pit, the guys on the floor
say, "Hey, what's your problem? It's only points!"

Some
contracts have associated daily price limits, which measure the maximum amount
that the market can move above or below the previous day's close in a single trading
session. Each Exchange determines whether a particular commodity has a daily trading
limit and for how much. The theory behind the limit-move rule is to allow
markets to cool down during particularly dramatic, volatile, or violent price
moves. For example, the rules for the soybean contract state that the market can
move up or down 50¢ per bushel from the previous close if it did not close
"limit" the previous day. (Limit moves result in expanded limits). So
if the market closes at $8.10 per bushel on Tuesday, then on Wednesday it can
trade as high as $8.60 or as low as $7.60. Contrary to popular belief, the market
can trade at the limit price; it just cannot trade beyond it. At times of dramatic
news or price movements, a market can move to the limit and "lock."
A lock-limit move means that there is an overabundance of buyers (for "lock
limit up") versus sellers at the limit-up price, or that there is an overabundance
of sellers (for "lock limit down") at the limit-down price.

For example, suppose that in a drought market, the weather services are
forecasting rain one weekend, thereby causing the market to trade lower on a Friday.
However, the rain never materializes, and on Monday morning, the forecast is back
to drought with record-high temperatures predicted for the week. Conceivably,
the market could open "up the limit" as shorts scramble to buy back
contracts previously sold, and buyers would be willing to "pay up" for
what appears to be a dwindling future supply of soybeans. Let's say the market
closed on Friday at $7.50 and that it opened at $8 on Monday. Now it could trade
at that price, or it could trade even lower that day. But suppose 20 million bushels
are wanted to buy at the limit-up price of $8, with only 10 million bushels to
sell. The first 10 million would trade at $8, with the second 10 million bushels
in the "pool" wanting and waiting to buy. If no additional sell orders
surface, the market would remain limit up that day, with unsatisfied buying demand
at the $8 level. However, there is nothing to say the market has to open higher
on Tuesday (it could unexpectedly rain Monday evening), but all other factors
remaining equal, this unsatisfied buying interest would most likely "gap
the market" higher on Tuesday morning.

In fact,
some markets have what are called variable limits, which is where the limits
are raised if a market closes limit up or limit down during a trading session.
Cattle is one of the markets with variable limits. If one or more contract months
close at the 3¢ (300-point) limit for two successive days, the limit is raised
to 5¢ on the next business day. (You can consult the Web sites of the various
Exchanges for the daily price-limit rules for each market.) Limit moves are rare,
but they do occur during shocks to a market. Pork bellies, for example, are notorious
for moving multiple limit days after an unexpectedly bullish or bearish "Hogs
and Pigs Report."

Here's a true story of how gutsy some of the floor
traders at the Board can be at times.

Bill,
who works our soybean orders, told me about one summer day when the soybean market
was down the limit. It wasn't just down the limit; it was "locked down the
limit," with five million bushels offered to sell down the limit and no buyers
in sight. It was very quiet. Then, out of nowhere, one large "local"
wanders into the pit and utters, "Take 'em.'' "How many?" they
ask. "All of 'em!'"

The other brokers in the pit literally
fell over themselves selling the entire five million to this guy. What could he
be thinking? But then, as soon as the five million were bought, and the quote
machines around the world tuned into soybeans showed this, the telephones around
the pit started to ring. Off the floor, traders around the world assumed with
such a big buyer at limit down that something was up, and they started to buy,
too. The market immediately started to rally. When it moved 5¢ per bushel
off the limit-down price, the large local stepped back in and sold his five million
bushels. It was a quick $250,000 profit, and it took only 20 seconds!

Trading
hours are set for each individual market by the Exchange. Cattle opens at
9:00 A.M. Chicago time on the Chicago Mercantile and closes at 1:00 P.M. sharp.
(If your order to sell reaches the cattle pit at 1:01 P.M., you're out of luck,
at least for that trading session.) As more and more markets become completely
electronic, trading hours won't matter as much as they used to. Many markets,
particularly the financials, trade on virtually a 24-hour basis. Most of the major
markets have after-hours trading, but some don't. If you miss the Live Cattle
close at 1:00 P.M. Chicago time, for example, you have no choice but to wait until
the next trading day. If you miss coffee, however, you can trade it in London,
but there is an eight-hour period where coffee futures are not traded anywhere
in the world. If you miss corn, on the other hand, which closes at 1:15 P.M. central
standard time (CST), you can trade it electronically at night from 5:30
P.M. until 4:00 A.M. the following morning.

To review thus far, before
you trade in any market, you need to know, at minimum, the Exchange the market
is traded on, the trading hours, the contract size, and the delivery months traded.
You need to know how prices are quoted, so that you can put them in the right
priced order, the minimum fluctuation, the dollar value of the minimum fluctuation,
and if there are any daily trading limits. You also need to know the types of
orders accepted at that particular marketplace. Finally, you want to know what
the margin requirement is for the market you are trading, and what commission
your broker will be charging. These topics are covered in the following sections.